Levi Strauss: FCF, Strong Efficiency, Gradual Sales Recovery

The pandemic dented the growth story of Levi Strauss & Co. (LEVI), a prominent apparel company that obviously does not need a wordy introduction. The stock that debuted on the NYSE in 2019 (for the second time, assuming its first listing in 1971) and attracted startling investor attention had however not been an outperformer, as, after the flotation, the price soared, but then was swiftly dragged down. And as sales growth came to a grinding halt in spring amid the hibernation of the economic activity, the share price took a battering that sent it materially below the IPO level. The overall market recovery has helped to par some losses, but LEVI is still ~8.8% cheaper than in March 2019.

However, given the company’s quick response to the mounting headwinds, its cash flow and efficiency even improved, which is vividly illustrated by the FQ3 results. More specifically, Levi’s has been undertaking cost-control measures while managing inventory conservatively. It even delivered a cash surplus, while sales are slowly but steadily climbing back to the pre-Covid-19 level. Besides, Wall Street is becoming more optimistic about growth prospects. Thus, I see no meaningful reasons to be stubbornly bearish.

Source: Unsplash

The top line

Though Wall Street had somber expectations for LEVI’s FQ3 sales and profits, it appeared that the market environment was not as depressed as pundits expected since cost control and margin optimization efforts buttressed the company’s profits. Thus, it topped both EPS and revenue estimates.

I acknowledge that EPS beats are always inspiring, but it does not mean FQ3 was a buoyant quarter. It was still overshadowed by a dismal revenue decline. As persisting ripple effects of the pandemic restrained sales at company-operated and third-party retail locations, the top line dipped 27%. Though the reduction was not as steep as in FQ2, when sales literally dropped like a stone, it still sent LTM revenues a few years back, approximately to the level of calendar mid-2017.

However, the silver lining is that Levi’s flexible business model helped it to slightly offset the toll the pandemic had taken on the supply chains and compensate for some lost revenues, as e-commerce sales surged 52% spurred by changing consumer buying habits. In the press release, explaining the momentum in e-commerce, Levi’s highlighted both higher traffic and higher conversion rates.

Speaking about the regional revenue mix, the Asian segment was most depressed. Sales in Asia virtually cratered, going from $213 million to just $123 million.

Source: the Form 8-K

Source: Form 8-K

I initially found it somewhat perplexing, as, for example, the Chinese economy is recovering by leaps and bounds, and the anecdotal evidence suggests that demand for apparel should also be robust. However, Levi Strauss gave a plausible explanation and clarified that the pivotal culprit was a steep decline in Indian sales. As the country was grappling with the wave of infections, restrictions imposed by the authorities led to slumped revenues. Also, the sales decline was so deep that the segment was the only operating loss-making. The Americas and Europe fared somewhat better, as the net revenues were down 29% and 16%, respectively. In both regions, the company reported a precipitous reduction in operating income, but it was still positive thanks to cost-cutting.

Understanding that the repercussions of the pandemic can have a long-lasting impact on the top line, Levi’s cut the expenses sharply. For example, its SG&A went down 18.7%, most likely influenced by layoffs. Unfortunately, the effect of the cost optimization on the bottom line was offset by increased interest expense, as the company made a preemptive step to protect liquidity and issued senior notes.

So, Levi’s did not turn a GAAP profit in the nine months of FY20. It is always disappointing to see when a prominent more than a 167-year-old company fails to cover its expenses, but I believe there are more relevant matters we should focus on when analyzing its profitability. The gist is that though closures of stores hamstrung sales and profits, LEVI’s managed to improve its net operating cash flow and deliver cash flow surplus, which looks especially impressive given the GAAP profit was sub-zero. Net CFFO for F9M touched $240.9 million, which is an over 17% improvement. FCF (before acquisitions) almost doubled, amounted to $151.4 million, reflecting a simultaneous reduction in capex and cash flow growth.

If we delve slightly deeper and look at what bolstered net CFFO despite profit that plummeted, we will notice that some hefty expenses were non-cash, thus, they had no impact on liquidity. For example, $61 million PP&E and right-of-use impairments were subtracted from operating income but added back to a net loss to arrive at net CFFO. Also, the company collected $219.8 million in trade receivables. In the Form 10-Q, I did not find any additional details on why the reduction was so significant; the management also did not discuss receivables during the earnings call.

When discussing earnings reports, I always take a quick look at how the company’s capital efficiency changed during the quarter. In the case of Levi’s, as net CFFO was bolstered by working capital improvement, Cash Return on Total Capital rose to ~17% from ~11% in FQ2. As a quick reminder, I consider companies with close to 20% CROTC highly efficient, and 17% is also a solid result. Besides, it is worth remarking that the improvement in the metric was driven mostly by a higher numerator – cash flow – while the denominator had almost not changed despite the debt issuance earlier this year.

Financial position

In April, Levi’s commenced a private placement of $300 million aggregate principal amount 5.00% senior notes due 2025. Its Debt/Equity went up; as of end FQ3, its D/E stood at ~132%. Anyway, I do not think it poses a threat to the growth story, as its net debt is minuscule given a $1.43 billion cash pile.

Management pointed to a recovery

As most of the pernicious effects of the pandemic had already abated, and the possibility of the full-scale shutdown of the economy is increasingly unlikely even in a bearish scenario, Levi’s management is expecting sales to climb back to the pre-coronavirus level “at some point in the second half of 2021.” Wall Street is also anticipating a much brighter 2021 if compared to a gloomy 2020. Analysts are forecasting an over 24% growth in FY21, and a less bumpy but steady expansion in fiscal 2022 and 2023, which is supportive of the bullish sentiment.

Conclusion

The unexpectedly robust FQ3 of Levi Strauss & Co., a prominent apparel company that went public last year, implies that the company is on the right track, and the soft share price performance has likely come to an end.

Also, there is a possibility that the dividend might return. As the CFO clarified during the call:

And while recovery trends are encouraging, there remains uncertainty about the future, and therefore, we will not be paying a dividend in the fourth quarter. If our positive business trends continue, we anticipate a return to paying quarterly dividends in 2021.

Though the pandemic hamstrung Levi Strauss’s growth story, the company shows progress returning to sales expansion, while it also demonstrates the ability to deliver cash profit even in the case of plummeting sales.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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